Musings on Markets

Saturday, February 10, 2018

The last week has been a roller coaster ride, though more down than up, and investors have done what they always do during market crises. The fear factor rises, some investors sell and head for the safer pastures, some are paralyzed not knowing what to do, and some double down as contrarians, buying into the sell off. In the last week, I found myself drawn to each of three camps, often at different points in the same day, as the market went through wild mood swings. These are my most vulnerable moments as an investor, since good sense is replaced by "animal spirits", and I feel the urge to abandon everything I know about investing, and go with my gut, never a good idea. I know that I have to step back from the action, regain perspective and return to what works for me in markets, and it is for that reason that I find myself going through the same sequence, each time I face a market crisis.

Step 1: Assess the damage and regain perspective

The first casualty in a crisis is perspective, as drawn into the news of the day, we tend to lose any sense of proportion. The last week has been an awful week for stocks, with many major indices down by 10% since last Thursday. If your initial investment in stocks was on February 1, 2018, I feel for you, because the pain has no salve, but most of us have had money in stocks for a lot longer than a week. In the table below, I look at the change in the S&P 500 last week and then compare it to the changes since the start of the year (which was less than 6 weeks ago) to a year ago and to ten years ago.

2/1/08

2/1/17

1/1/18

2/1/18

S&P 500 on date

1355

2279

2674

2822

S&P 500 on 2/8/18

2581

2581

2581

2581

% Change

90.48%

13.25%

-3.48%

-8.54%

I know that this is small consolation, but if you have been invested in stocks since the start of the year, your portfolio is down, but by less than 3.5%. If you have been invested a year, you are still ahead by 13.25%, even after last week, and if you've been in stocks, since February 2008, you've not only lived through an even bigger market crisis (with the S&P 500 down 38% between September 2008 and March 2009), but you have seen your portfolio climb 90.48% over the entire period, and that does not even include dividends. That is why when confronted by perpetual bears, with their "I told you so" warnings, I try to remember that most of them have been bearish since time immemorial.

Returning the focus to the last week, let's first look across sectors to see which ones were punished the most and which ones endured. Using the S&P classification for sectors, here is how the sectors performed between February 2, 2018 and February 9, 2018;

Not surprisingly, every sector had a down week, though energy stocks did worse than the rest of the market, with an oil price drop adding to the pain. Continuing to look at equities, let's now look geographically at returns in different markets over the last week.

While the S&P 500 had a particularly bad week, the rest of the world felt the pain, with only one index (Colombo, Sri Lanka) on the WSJ international index list showing positive returns for the week. In fact, Asia presents a dichotomy, with the larger markets (China, Japan) among the worst hit and the smaller markets in South Asia (Thailand, Indonesia, Malaysia and Philippines) showing up on the least affected list.

While equities have felt the bulk of the pain, it is interest rates that have been labeled as the source of this market meltdown, and the graph below captures the change in treasury rates and corporate bonds in different ratings classes (AAA, BBB and Junk) over the last week and the last year:

The treasury bond rate rose slightly over the week, at odds with what you usually see in big stock market sell offs, when the flight to safety usually pushes rates down. The increases in default spreads, reflected in the jumps in interest rates increasing with lower ratings, is consistent with a story of a increased risk aversion. Here again, taking a look across a longer time period does provide additional information, with treasury rates at significantly higher levels than a year ago, with a flattening of the yield curve. In summary, this has been an awful week for stocks, across sectors and geographies, and only a mildly bad week for bonds. Looking over the last year, it is bonds that have suffered a bad year, while stocks have done well. That said, the rates that we see on treasuries today are more in keeping with a healthy, growing economy than the rates we saw a year ago.

Step 2: Read the tea leaves

It is natural that when faced with large market moves, we look for logical and rational explanations. It is in keeping then that the last week has been full of analysis of the causes and consequences of this market correction. As I see it, there are three possible explanations for any market meltdown over a short period, like this one:

Market Meltdowns: Reasons, Symptoms and Consequences

Explanation

Symptoms

Market
Consequences

Panic Attack

Sharp
movements in stock prices for no discernible reasons, with surge in fear
indices.

Market
drops sharply, but quickly recovers back most or all of its losses as panic
subsides

Market
drops sharply and stays down, with price moves tied to the fundamental(s) in
focus.

Repricing of
Risk

Event
or news that leads to repricing of risk (in the form of equity risk premiums
or default spreads).

As price of risk is reassessed upwards, market drops until the price of risk
finds its new equilibrium.

The question in any meltdown is which explanation dominates, since stock market crisis has elements of all three. As I look at what's happened over the last week, I would argue that it was triggered by a fundamental (interest rates rising) leading to a repricing of risk (equity risk premiums going up) and to momentum & fear driven selling.

The Fundamentals Trigger: This avalanche of selling was started last Friday (February 1, 2018) by a US unemployment report that contained mostly good news, with 200,000 new jobs created, a continuation of a long string of positive jobs reports. Included in the report, though, was a finding that wages increased 2.9% for US workers, at odds with the mostly flat wage growth over the last decade. That higher wage growth has both positive and negative connotations for stock fundamentals, providing a basis for strong earnings growth at US companies that is built on more than tax cuts, while also sowing the seeds for higher inflation and interest rates, which will make that future growth less valuable.

The Repricing of Equity Risk: That expectation of higher interest rates and inflation seems to have caused equity investors to reprice risk by charging higher equity risk premiums, which can be chronicled in a forward-looking estimate of an implied ERP. I last updated that number on January 31, 2018, and I have estimated that premium, by day, over the five trading days between February 1 and February 8, 2018. There is little change in the growth rates and base cash flows, as you go from day to day, partly because neither is updated as frequently as interest rates and stock prices, but holding those numbers, the estimated equity risk premium has increased over the last week from 4.78% at the start of trading on February 1, 2018 to 5.22% at the close of trading on February 8, 2018.

Implied ERP, by Day: January 31, 2018 (Close) to February 8, 2018 (Close)

The Panic Response: Most market players don't buy or sell stocks on fundamentals or actively think about the price of equity risk. Instead, some of them trade, trying to take advantage of shifts in market mood and momentum, and for those traders, the momentum shift in markets is the only reason that they need, to go from being stock buyers to sellers. Others have to sell because their financial positions are imperiled, either because they borrowed money to buy stocks or because they fear irreparable damage to their retirement or savings portfolios. The rise in the volatility indices are a clear indicator of this panic response, with the VIX almost tripling in the course of the week. Just in case you feel the urge to blame millennials, with robo-advisors, for the panic selling, they seem to be staying on the side lines for the most part, and it is the usual culprits, "professional" money managers, that are most panicked of all.

At this point, you are probably confused about where to go next. If you are trying to make that judgment, you have to find answers to three questions:

Where are interest rates headed? There has been a disconnect between the equity and the bond market, since the 2016 US presidential election, with the equity markets consistently pricing in more optimistic forecasts for the US economy, than the bond markets. Stocks prices rose on the expectation that tax cuts and more robust economic growth, but bond markets were more subdued with rates continuing to stay at the 2.25%-2.5% range that we have seen for much of the last decade. As I noted in my post at the start of this year on equity markets, the gap between the US 10-year T.Bond rate and an intrinsic measure of that rate, computed by adding inflation to real GDP growth, has widened to it's highest level in the last decade. The advent of the new year seems to have caused the bond market to notice this gap, and rates have risen since. If you are optimistic about the US economy and wary about inflation, there is more room for rates to rise, with or without the Fed's active intervention.

Is the ERP high enough? Is the repricing of equity risk over? The answer depends upon whether you believe the numbers that underlie my estimates, and if you do, whether you think 5.22% is a sufficient premium for investing in equities. The only way to address that question is to examine it in the context of history, which is what I have done in the picture below:

With all the caveats about the numbers that underlie this graph in place, note that the premium is now solidly in the middle of the distribution. There is always the possibility that the earnings growth estimates that back it up are wrong, but if they are, the interest rate rise that scares markets will also be reversed.

When will the panic end? I don't know the answer to the question but I do know that it rests less on economics and more on psychology. There will be a moment, perhaps early next week or in two weeks or in two months, where the fever will pass and the momentum will shift. If you are a trader, you can get rich playing this game, if you play it well, or poor in a hurry, if you play it badly. I choose not to play it all.

Is there a way that we can bring this all together into a judgment call in the market. I think so and I will use the same framework that I used for my implied equity risk premium to make my assessment. You will need three numbers, an expected growth rate in earnings for the S&P 500, you estimate of where the 10-year treasury bond rate will end up and what you think is a fair equity risk premium for the S&P 500. For instance, if you accept the analyst forecasted growth in earnings of 7.26% for the next five years as a reasonable estimate, that the the T.Bond rate will settle in at about 3.0% and that 5.0% is a fair value for the equity risk premium, your estimate of value for the S&P 500 is below:

With these estimates, you should be okay with how the market is valuing equities at the close of trading February 8, 2018; it is slightly under valued at 3.90%. To provide a contrast, if you feel that analysts are over estimating the impact of the tax cuts and that the historical earnings growth rate over the last decade (about 3.03%) is a more appropriate forecast for future growth, holding the risk free rate and ERP at 3% and 5% respectively, the value you will get for the index is 2233, about 16% below the index level of February 8, 2018. If you want put in your own estimates of earnings growth, T.Bond rates and equity risk premiums, please download this spreadsheet. In fact, if you are inclined to share your estimates with a group, I have created a shared google spreadsheet for the S&P 500. Let's see what we can get as a crowd valuation.

Step 3: Review your investment philosophy

I firmly believe that to be a successful investor, you need a core investment philosophy, a set of beliefs of not just how markets work but who you are as a person, and you need to stay true to that philosophy. It is the one common ingredient that you see across successful investors, whether they succeed as pure traders, growth investors or value investors. The best way that I can think of presenting the different choices you have on investment philosophies is by using my value/price contrast:

To the question of which of these is the best philosophy, my answer is that there while there is one philosophy that is best for you, there is no one philosophy that is best for all investors. The key to finding that "best" philosophy is to find what makes you tick, as an individual and an investor, not what makes Warren Buffett successful.

I see myself as an investor, not a trader, and that given my tool kit and personality, what works for me is to be a investor grounded in value, though my use of a more expansive definition of value than old-time value investors, allows me to buy both growth stocks and value stocks. I am not a market timer for two reasons.

First, the overall market has too many variables feeding into it that I do not control and cannot forecast, making my valuations inherently too noisy to be useful.

Second, I see little that I bring to the overall market in terms of tools or information that will give me an edge over others.

The truest test of whether you have a solid investment philosophy is a week like the last one, where you will be tempted to or panicked into abandoning everything that you believe about markets. I would lying if I said that I have not been tempted in the last week to time markets, either because of fear (driving me to sell) or hubris (where I want to play market contrarian), but so far, I have been able to hold out.

Step 4: Act consistently
During every market crisis, you will be tempted to look and ask that ever present question of "What if?", where you think about all of the money you could have saved, if only you had sold last Thursday. Not only is this pointless, unless you have mastered time travel, but it can be damaging to your future returns, as your regrets about past actions taken and not taken play out in new actions that you take. My suggestion is that you return to your core investment philosophy and start to think about the actions that you can take on Monday, when the market opens, that would be consistent with that philosophy. I am taking my own suggestion to heart and have started revisiting the list of companies that I would love to invest in (like Amazon, Netflix and Tesla), but have been priced out of my reach, in the hope that the correction will put some of them into play. More painfully, I have been revaluing every single company in my existing portfolio, with the intent of shedding those that are now over valued, even if they have done well for me. If nothing else, this will keep me busy and perhaps stop me from being caught up in the market frenzy!

Monday, February 5, 2018

In my first nine posts on my data update for 2018, I focused on the costs that companies face in raising equity and debt, and their investment, financing and dividend decisions. In assessing those decisions, though, I looked at their actions through the lens of value creation, arguing that investing in projects that earn less than their cost of capital is not a good use of shareholder capital. While this may seem like a reasonable conclusion, it is built on the implicit assumption that financial markets reward value creation and punish value destruction. As any market observer will tell you, markets have minds of their own, sometimes rewarding companies for bad behavior and punishing companies that take the right actions. In this post, I look at market pricing around the world, and point to potential inconsistencies with the fundamentals.

Value vs Price

In multiple posts on this blog, I have argued that we need to stop using the words, value and price, interchangeably, that they not only can be very different for the same asset, at any point in time, but that they are driven by different forces, require different mindsets to understand, and give rise to different investment philosophies. The picture below summarizes the key distinctions:

Understanding the difference between value and price, at least for me, is freeing, because it not only makes me aware of the assumptions that I, as an investor who believes in value and convergence, am making, but also makes me respect and recognize those who might have a different perspective. The bottom line, though, is that the pricing process can sometimes reward firms that take actions that no tonly have no effect on value, but may actually destroy value, and punish firms that are following financial first principles. Even though I believe that value ultimately prevails, it behooves to me to try to understand how the market is pricing stocks, since it will help me be a better investor.

The Pricing Process

I will begin with what sounds like a over-the-top assertion. Much of what we see foisted on us as valuation, including those that you see backing up IPOs, acquisitions or big investment decisions, are really pricing models, masquerading as valuations. In many cases, bankers and analysts use the front of estimating cash flows for a discounted cashflow valuation, while slipping in a multiple to estimate the biggest cash flow (the terminal value) in what I call Trojan Horse DCFs. I am not surprised that pricing is the name of the game in banks and equity research, but I am puzzled at why so much time is wasted on the DCF misdirection play. There are four steps to pricing an asset or company well, and done well, there is no reason to be ashamed of a pricing.

1. Similar, Traded Assets

To price an asset, you have to find "similar" assets that are traded in the market. Note the quote marks around similar, because with publicly traded stocks, you will be required to make judgment calls on what you view as similar. The conventional practice in pricing seems to be country and sector focused, where an Indian food processing company is compared to other food processing companies in India, on the implicit assumption that these are the most comparable companies. That practice, though, can not only lead to very small samples in some countries, but also can yield companies that have very different fundamentals from the company that you are valuing.

1.1: With equities, there are no perfect matches: If you are valuing a collectible (Tiffany lamp or baseball card), you might be able to find identical assets that have been bought and sold recently. With stocks, there are no identical stocks, since even with companies that are close matches, differences will persist.

1.2: Small, more similar, sample or large, more diverse, sample: Given that there are no stocks identical to the one that you are trying to value in the market, you will be faced with two choices. One is to define "similar" narrowly, looking for companies that are listed on the same market as yours, of similar size and serving the same market. The other is to define "similar" more broadly, bringing in companies in other markets and perhaps with different business models. The former will give you more focus and perhaps fewer differences to worry about and the latter a much larger sample, with more tools to control for differences.

2. Pricing Metric

To compare pricing across companies, you have to pick a pricing metric and broadly speaking, you have three choices:

The market capitalization is the value of equity in a business, the enterprise value is the market value of the operating assets of the firm and the firm value is the market value of the entire firm, including any cash and non-operating assets. While firm value is lightly used, because non-operating assets and cash can skew it, both enterprise value and equity value are both widely used. In computing these metrics, there are three issues that do complicate measurement. One is that market capitalization (market value of equity) is constantly updated, but debt and cash numbers come from the most recent balance sheets, creating a timing mismatch. The second is that the market value of equity is easily observable for publicly traded companies, but debt is often not traded (if bank debt) and book debt is used as a stand in for market debt. Finally, non-operating assets often take the form of holdings in other companies, many of which are private, and the values that you have for them are book values.

2.1: When leverage is different across companies, go with enterprise value: When comparing pricing across companies, it is better to focus on enterprise value, when debt ratios vary widely across the companies, because equity value at highly levered companies is much smaller and more volatile and cannot be easily compared to equity value at lightly levered companies.

2.2: With financial service companies, stick with equity: As I have argued in my other posts, debt to a bank, investment bank or insurance company is more raw material than source of capital and defining debt becomes almost impossible to do at financial service firms. Rather than wrestle with his estimation problem, my suggestion is that you stick with equity multiples.

3. Scaling Variable

When pricing assets that come in standardized units, you can compare prices directly, but that is never the case with equities, for a simple reason. The number of shares that a company chooses to have will determine the price per share, and arguing that Facebook is more expensive than Twitter because it trades at a higher price per share makes no sense. It is to combat this that we scale prices to a common variable, whether it be earnings, cash flows, book value, revenues or a driver of revenues (users, riders, subscribers etc.).

3.1: Be internally consistent: If your pricing metric is an equity value, your scaling variable has to be an equity value (net income, book value of equity). If your pricing metric is enterprise value, your scaling variable has to be an operating variable (revenues, EBITDA or book value of invested capital).

3.2: Life cycle matters: The multiple that you use to judge pricing will change, as a company moves through the life cycle.

Early in the life cycle, the focus will be on potential market size or revenue drivers, since the company's own revenues are small or non-existent and it is losing money. As it grows and matures, you will see a shift to equity earnings first, since growth companies are mostly equity funded, and then to operating earnings and EBITDA, as mature companies use debt, ending with a focus on book value as a proxy for liquidation value, in decline.

4. Control for differences

As we noted, when discussing similar companies, no matter how carefully you pick comparable firms, there will be differences that persist between the company that you are trying to value and the comparable firms. The test of good pricing is whether you detect the variables that cause differences in pricing and how well you control for the differences. In much of equity research, the preferred mode for dealing with these differences is to spin them to justify whatever pre-conceptions you have about a stock.

4.1: Check the fundamentals: In intrinsic value, we argued that the value of a company is a function of its cash flows, growth and risk. If you believe that the fundamentals ultimately prevail in markets, you should tie the multiples you use to these fundamentals, and using algebra and a basic discounted cash flow model will lead you to fundamentals drivers of any multiple.

4.2: Let the market tell you what matters: If you are a pure trader, who has little faith that the fundamentals will prevail, you can can take a different path. You can look at other data, related to the companies that you are pricing, and look for correlation. Put simply, you are trying to use the data to back out what variables best explain differences in market pricing, and using those variables to price your company.

To illustrate the differences between the two approaches, take a look at my pricing of Severstal, where I used fundamentals to conclude that it was under priced, and my pricing of Twitter, at the time of its IPO, where I backed out the number of users as the key variable driving the market pricing of social media companies and priced Twitter accordingly.

Pricing around the Globe

Assuming that you have had the patience to get to this part of the post, let's look at the pricing numbers at the start of 2018, around the world, starting with earnings multiples (PE and EV/EBITDA), moving on to book value multiples (Price to Book, EV to Invested Capital) and ending with revenue multiples (EV/Sales).

1. Earnings Multiples

Earnings multiples have the deepest roots in pricing, with the PE ratio still remaining the most used multiple in the world. In the last two to three decades, there has been a decided shift towards enterprise value multiples, with EV/EBITDA leading the way. While I am skeptical of EBITDA as a measure of accessible cash flow, since it is before taxes and capital expenditures, I understand its pull, especially in aging companies with significant depreciation charges. If you assume that depreciation will need to go back into capital expenditures, there is an intermediate measure of pricing, EV to EBIT.

In the chart below, I look at the distribution of PE ratios globally, and report on the PE ratio distributions, broken down region, at the start of 2018.

I know that it is dangerous to base investment judgments on simple comparisons of pricing multiples, but at the start of 2018, the most expensive market in the world on a PE ratio basis, is China, followed by India, and the cheapest market is Eastern Europe and Russia. If you would like to see the values for earnings multiples, by country, please click at this link.

If you are more interested in operating earnings multiples, the chart below has the distribution of EV/EBIT and EV/EBITDA multiples:

China again tops the scale, with the highest EV/EBITDA multiples, and Eastern Europe and Russia have the lowest EV/EBITDA multiples. Earnings multiples also vary across sectors, with some of the variation attributable to fundamentals (differences in growth, risk and cash flows) and some of it to misplacing. The sectors that trade at the highest and lowest PE ratios are identified below:

You can download the full list of earnings multiples for all of the sectors, by clicking on this link.

2. Book Value Multiples

The delusion of fair value accounting is that balance sheets will one day provide better estimates of how much a business in worth than markets, and while I believe that day will never come, even accountants are entitled to their dreams. That said, there are investors who still put their faith in book value and compare market prices to book value, either in equity terms or operating asset terms:

In the table below, I report on price to book and enterprise value to invested capital ratios, by sub-region of the world:

The most expensive sub-region of the world is India, on both a price to book and EV/Invested capital basis, and the lowest priced stocks are again in Eastern Europe and Russia. If you would like to see book value multiples, by country, click at this link. With book value multiples, the differences you observe across sectors not only reflect differences in fundamentals and pricing errors, but also accounting inconsistencies on how capital expenditures in non-manufacturing companies are dealt with, as opposed to manufacturing firms. I tried to correct for these inconsistencies, by capitalizing R&D at all firms, but that correction goes only part way and the most expensive and cheapest sectors, with my corrected book values, are listed below:

You can download the book value multiple data, by sector, by clicking here.

3. Revenue Multiples

To the question of why investors and analysts look at multiples of revenues, my one word answer is "desperation". When every other number in your income statement is negative, you have to keep climbing the statement until you hit a positive value. That said, there is value in focusing on a variable that accountants have the least influence over, and the heat map below captures differences in the enterprise value to sales ratios across the globe.

Unlike earnings and book value multiples, which have a pronounced peak in the middle of the distribution, revenue multiples are more evenly distributed, with quite a few firms trading at more than ten times revenues. As with earnings and book value multiples, I report revenue multiples, by country at this link and by sector at this link. Note that there no revenue multiples reported for financial service firms, where neither enterprise value nor revenues can be meaningfully measured or estimated.

Conclusion

I am an investor, who believes in value, but it would be foolhardy on my part to ignore the pricing game, since I am dependent upon it ultimately to cash out on my value gains. In this post, I have looked at the pricing differences around the globe, at least based upon market prices at the start of 2018. Of all of my data posts, this is the one that is the most dynamic and likely to change over short periods, since markets can react to change far more quickly than companies can.

Sunday, February 4, 2018

If success for a farmer is measured by his or her harvest, success in a business, from an investors' standpoint, should be measured by its capacity to return cash flows for its owners. That is not belittling the intermediate steps needed to get there, since to be able to generate these cash flows, businesses have to find ways to treat employees well, satisfy customers and leave society at ease with their existence, but the end game does not change. That is why I find it surprising that when companies pay dividends, or worse still, buy back stock, there are so many who seem to view them as failures. Perhaps, that flows from the misguided view that reinvesting cash is good, not just for the company but also for the economy, because it creates growth and returning cash is bad, because it is somehow wasted, both flawed arguments. A company that reinvests cash in a bad business is destroying value, not adding to it, and as we saw in my post on excess returns, a preponderance of companies globally earn less than their costs of capital. Cash that is returned is not lost to the economy, but much of it is reinvested back into other businesses that often have much better investment opportunities. That said, the way companies determine how much to return to shareholders, either as dividends or in the form of buybacks, is grounded in inertia and me-tooism.

Dividends' Place in the Big Picture

In my corporate finance classes, I present what I term the big picture of corporate finance and the first principles that should govern how a business is run:

If you view dividends as residual cash flows, which is what they should be, the sequence that leads to dividends is simple. Every business should start by looking at its investment opportunities first, then finding a financing mix that minimizes its hurdle rate and then based upon its investment and financing choices, determine how much to pay out as dividends.

Note that this sequence holds only if capital markets (debt and equity) remain open, accessible and fairly priced, and companies have no self imposed constraints on raising capital or dividend payments. Those are clearly big and perhaps unrealistic assumptions for most companies, especially so for small firms and companies in emerging market, and that is why I have titled it Dividend Utopia. In the real world, there are multiple constraints, some external and some internal, that change the sequence.

Capital markets are not always open and accessible: In utopian corporate finance, a company with a good investment opportunity, i.e., one that earns more than the cost of capital can always raise capital from equity or debt market, quickly, at a fair price and with little or no issuance costs. In the real world, capital markets are not that accommodating. Raising capital can be a costly exercise, investors may under price your debt and equity, and the process can take time. It should come as no surprise then that if a company pays too much in dividends in this setting, it will find itself rejecting good investments.

Banks may be the only lending option: For many companies, the only option when it comes to borrowing money is to go to a bank, and to the extent that banks face their own constraints on lending, companies may be unable to borrow at what they perceive to be fair rates. This will effectively play out in both investing and financing decisions.

Dividends are sticky: If there is one word that characterizes dividend policy around the world, it is that it is "sticky". Companies, once committed to paying dividends, are unwilling to either cut or stop paying dividends, for fear of market punishment. That stickiness translates into companies continuing to pay dividends, even as earnings collapse and/or investment opportunities expand.

In a world with these constraints, dividends are no longer a residual cash flow, determined by choices you make on investments and financing, but a determinative cash flow, driving investment and financing decisions. If you add the desire of companies to pay dividends similar to those that they have in the past (inertia) and to be like the rest of the sector (me-too-ism) and irrational fears of dilution and debt, you have the makings of dysfunctional dividends.

In this circular universe, by putting dividend and financing decisions first, companies can end up with too much or too little capital available for projects, and in this dysfunctional universe, they adjust discount rates to make investment demand equate to supply. I never cease to be surprised by companies that claim to use hurdle rates as high as 20% and as low as 3%, both numbers that are out of the range of any reasonable cost of capital computation. In extreme cases, you can have dividend insanity, where companies that are losing money and are already over levered borrow even more money to pay dividends, making their cash flow deficits worse, leading to more losses, more debt and more dividends.

Dividends across the Life Cycle

If dividends are, in fact, a residual cash flow, estimating how much you can afford to pay is a simple exercise of starting with the cash flows from operations that equity investors generate and netting out investment cash flows and cash flows to and from debt.

In effect, everything you need to estimate this potential dividend or free cash flow to equity (FCFE) should be in the statement of cash flows for a firm. This measure of potential dividends can be utilized, with my corporate life cycle framework, to frame how dividend policy should evolve over a company's life, if it were truly residual.

Note that the FCFE is the cash that is available for return and that companies can choose to return that cash as traditional dividends or in buybacks. If they choose not to do so, the cash will accumulate as a cash balance at the company.

The Compressed Life Cycle and Consequences

In this post from a while back, I argued that as we have shifted from the smoke stack and manufacturing sectors of the last century to the technology and service companies of the modern era, life cycles have compressed, creating challenges for both managers and investors.

That compressed life cycle has consequences for both how much companies can return to shareholders and in what form:

Once mature, companies will return more cash over shorter periods: The intensity of both the growth and the decline phases, with compressed life cycles, will mean that companies will become larger much more quickly than they used to, both in terms of revenues and earnings, but once they hit the "growth wall", they will find investment opportunities shrinking much faster, thus allowing for more cash to be returned over shorter time periods.

Those cash returns will be more likely to be in buybacks or special dividends, not regular dividends: The sweet spot for conventional dividends is the mature phase, where companies get to enjoy their dominance and rest on their competitive advantages, with large and predictable earnings. With the life cycle shortening and becoming more intense, this sweet spot period has become much briefer. Think of how little time Yahoo! and Blackberry got to enjoy being mature companies, before decline kicked in. Even the rare tech companies, like Microsoft and Apple, that have managed to extend their mature phases have to reinvent themselves to keep generating their earnings, making these earnings more uncertain. Paying large regular dividends in this setting is foolhardy, since investors expect you to keep paying them, in good times and bad.

Companies that fight aging will see bigger cash build ups: No company likes to age, and it should not come as a surprise that many tech companies fight the turn in their life cycles, deluding themselves into believing that a rebirth is around the corner and not returning cash., even as free cash flows to equity turn positive. At these companies, cash balances quickly balloon, attracting activist investors.

In short, much of what managers and investors know or expect to see in dividend policy reflects a different age and time. It should come as no surprise that older investors, especially ones that grew up with Graham and Dodd as their investing bible find this new world bewildering. I can offer little consolation, since globalization and disruption will only make things more unstable and less suited to paying large, stable dividends.

Cash Return Numbers

Having laid the foundations for understanding the shifts that are occurring in dividend policy, we have a structure for putting the numbers that we will see in this section in perspective. I will start this section by looking at regular dividends and conventional measures of these dividends (dividend yield and payout ratios) but then expand cash return to include stock buybacks and how metrics that capture its magnitude and close by looking at cash balances at companies.

Regular Dividends

There are two widely used measures of dividends paid. One is to scale the dividends to the earnings, resulting in a payout ratio. That number, to the extent that you trust accounting income and dividends are the only way of returning cash to stockholders plays a dual role, telling cash-hungry investors how much the company will pay out to them, and growth-seeking investors how much is being put back into the business, to generate future growth (with a retention ratio = 1 - payout ratio). The picture below captures the distribution of payout ratios across the globe, with regional sub-group numbers embedded in a table in the picture:

Note that the payout ratio cannot be computed for companies that pay dividends, while losing money, and that it can be greater than 100% for companies that pay out more than their earnings. Japan has the lowest dividend payout ratio, across regions, a surprise given the lack of growth in the Japanese economy., and Australian companies pay out the higher percentage of their earnings in dividends.

The other measure of dividends paid is the dividend yield, obtained by dividing dividends by the market capitalization. This captures the dividend component of expected return on equities, with the balance coming from expected price appreciation. To the extent that dividends are sticky and thus more likely to continue over time, stocks with higher dividend yields have been viewed as safer investments by old time value investors. The picture below has the distribution of dividend yields for global companies at the start of 2018, with regional sub-group numbers embedded:

As with the payout distribution, there are outliers, with companies that deliver dividends yields in the double digits. While these companies may attract your attention, if you are fixated on dividends, these are companies that are almost certainly paying far more dividends that they can afford, and it is only a question of when they will cut dividends, not whether. With both measures of dividends, there is a hidden statistic that needs to be emphasized. While these charts look at aggregate dividends paid by companies and present a picture of dividend plenty, the majority of companies in both the US (75.8%) and globally (57.6%) pay no dividends. The median company in the US and globally pays no dividends.

Buybacks

There is a great deal of disinformation out there about stock buybacks and I tried to deal with them in this post from a couple of years ago. The reality is that stock buybacks have largely replaced dividends as the primary mechanism for returning cash to stock holders, at US companies. In 2017, buybacks represented 53.69% of all cash returned by US companies, but the shift to stock buybacks is starting to spread to other parts of the globe, as can be seen in the regional breakdown below:

Sub Group

Number of firms

Dividends

Dividends + Buybacks

Buybacks as % of Cash Returns

Africa and Middle East

2,277

$65,767

$70,530

6.75%

Australia & NZ

1,777

$50,194

$56,034

10.42%

Canada

2,850

$49,544

$80,470

38.43%

China

5,552

$317,678

$342,282

7.19%

EU & Environs

5,399

$320,027

$514,279

37.77%

Eastern Europe & Russia

558

$21,761

$23,522

7.49%

India

3,511

$20,701

$27,121

23.67%

Japan

3,755

$101,760

$134,087

24.11%

Latin America

880

$40,395

$47,907

15.68%

Small Asia

8,630

$128,066

$148,607

13.82%

UK

1,412

$101,605

$128,161

20.72%

United States

7,247

$486,009

$1,049,487

53.69%

While US companies still return more cash in the form of buybacks than their global counterparts, European and Canadian companies also return approximately 38% of cash returned in buybacks, and even Indian companies are catching on (with about 24% returned in buybacks). If you are interested in how much cash companies in different countries return, and in what form, you can check this list, or the heat map below (you can see the dividend yield and payout ratios, by country, in the live version of the map):

There are differences in how companies return cash, across sectors, and the table below lists the ten sectors that return the most and the least cash, in the form on buybacks, as a percent of cash returned.

Commodity companies and utilities are still more likely to return cash in the form of dividends, while software and technology companies are more likely to use buybacks. If you are interested, you can download the entire sector list, with dividends, buybacks and associated statistics.

Cash Balance
There is one final loose end to tie up on dividends. If companies don't return their FCFE (potential dividends) to stockholders, it accumulates as a cash balance. One way to measure whether companies are returning enough cash is to look at cash balances, scaled to either the market values of these firms or market capitalization. The table below provides the regional statistics on cash balances:

Sub Group

Cash Balance

Cash/Firm Value

Cash/ Market Cap

Africa and Middle East

$490,475

16.13%

24.43%

Australia & NZ

$175,578

6.43%

11.37%

Canada

$183,204

4.66%

8.10%

China

$2,724,851

12.84%

21.16%

EU & Environs

$2,935,769

11.85%

22.43%

Eastern Europe & Russia

$112,480

15.08%

24.34%

India

$99,190

3.31%

4.18%

Japan

$4,185,572

34.47%

67.73%

Latin America

$239,664

7.84%

13.06%

Small Asia

$841,230

9.91%

15.19%

UK

$1,087,286

15.80%

29.48%

United States

$2,206,548

4.73%

7.52%

Japan is clearly the outlier, with cash representing about 34% of firm value, and an astonishing 68% of market capitalization. It may be a casual empiricism, but it seems to me that Japan is filled with walking dead companies, aging companies whose business models have crumbled but are holding on to cash in desperate hope of reincarnation. It is the Japanese economy that is paying the price for this recalcitrance, as capital stays tied up in bad businesses and does not find it way to younger, more vibrant businesses.

Conclusion

If the end game in business, for investors, is the generation and distribution of cash flows to them, many companies and investors seem to be stuck in the past, where long corporate life cycles and stable earnings allowed companies to pay large, steady and sustained dividends. Facing shorter life cycles, global competition and more unpredictable earnings, it should come as no surprise that companies are looking for more flexible ways of returning cash, than paying dividends and that buybacks have emerged as an alternative. As companies take advantage of the new tax law and bring back trapped cash, some will undoubtedly use the cash to buy back stock, and be loudly declaimed by the usual suspects, for not putting the cash to "productive" uses. I would offer two counters, the first being my post on excess returns where I note that more than 60% of global companies destroy value as they try to reinvest and growth, and the second being that it is better for economies, for aging companies to give cash back to stock holders, to invest in better businesses.

Monday, January 29, 2018

In the United States, as in much of the rest of the world, and as has been true for most of the last century, the tax code has been tilted towards debt, rewarding firms that borrow money with tax savings, relative to those that use equity to fund their operations. While the original rationale for this debt bias was to allow the large infrastructure companies of the equity markets (railroads, followed by phone and natural resource companies) to raise financing to fund their growth, that reason has long dissipated, but a significant segment of the economy is built on debt. The most revolutionary component of the US tax reform package that passed at the end of last year is that it reduces the benefits of debt in multiple ways, and by doing so, challenges companies that have long depended on debt to reexamine their financing policies.

The Trade Off on Debt and the Tax Reform Package

In last year’s update on debt, I summarized the trade off on debt, listing both the real pluses and minuses of debt as well as what I called the illusory benefits. In the latter group, I included reasons like debt is cheaper than equity and dilution benefits:

The bottom line is that it is the tax advantage of debt that makes it attractive to equity, and the benefits to borrowing were greater in the United States than in any other country last year, for a simple reason. The US had the highest marginal corporate tax rate in the world, at 40%, and companies that borrowed effectively claimed their tax benefits at that rate. To the oft touted counter that no US companies pay 40%, that is true, but it actually makes the tax benefit of debt even more perverse. Companies in the United States have been able to pay effective tax rates well below 40%, while maximizing their tax benefits from debt. As an example, consider Apple, which paid an effective tax rate of less than 25% on its global income last year, partly because it left so much of its foreign income off shore (as trapped cash). Apple still managed to borrow almost $110 billion in the United States, and claim the interest expenses on that debt as a tax deduction against its highest taxed income (its US income). For those of you who find this unethical, please spare me the moralizing since your disdain should be directed at those who wrote the tax code.

As I noted in my post on the changes that tax reform is bringing, the biggest are going to be to the tax benefits of debt, which will be dramatically decreased starting this year, for two reasons:

Lower marginal tax rate: The marginal tax rate for the United States has gone from being the highest in the world to close to the middle. At a 24% marginal tax rate, which is where I think we will end up with state and local taxes added to the new federal tax rate of 21%, you are effectively reducing the tax benefit of debt by about 40% (from 40% to 24%). In the heat map below, I have highlighted marginal tax rates of countries, with a highlighting in shades of rec of those that will have lower marginal tax rates than the US after 2018. To provide a contrast, this picture would have been entirely in shades of red last year, before the tax rate change, since there was no other country with a corporate tax higher than 40%.

Limits on interest tax deductions: Until last year, as has been the case for much of the last century, US companies have been able to claim their interest expenses as tax deductions, as long as they have the income to cover these expenses. With the new tax code, there is a limit to how much interest you can deduct, at 30% of adjusted taxable income. Any excess interest expenses that cannot be deducted can be carried forward and claimed in future years, and that provision will help companies with volatile earnings, since they will be able to claim back deductions lost in a bad year, in good years. As is its wont, Congress has chosen to make up its own definitions of adjusted taxable income, with EBITDA standing on for operating income until 2021 and then transitioning to earnings before interest and taxes (EBIT).

There are two other provisions in the tax code which will also indirectly affect the debt trade off.

Capital Expensing: Attempting to encourage investments in physical assets, especially at manufacturing companies, the tax code will allow companies to expense their capital investments for a temporary period. The resulting tax deductions may be large enough to reduce the benefit to having the interest tax deduction. That effect will be magnified by the fact that the companies that are most likely to be using the capital expensing provisions are also the companies that have used debt the most in funding their operations.

Un-trapped Cash: As companies are allowed to pay a one-time tax and bring trapped cash back to the United States, the cash will be now available for other uses and reduce the need for debt as a funding source. Note that estimates of this trapped cash, collectively held by US companies, exceed $3 trillion and that even if only half of this cash is brought back, it would still be a substantial amount.

All in all, there are multiple provisions in the tax code that handicap the use of debt and very few, perhaps even none, that would make debt a more attractive source of financing.

Optimal Capital Structure

To quantify the impact of the tax code’s change on how much debt a company should have and how much value it adds, I used an old but flexible optimizing tool: the cost of capital. It is, of course, the number around which a post looking at how it varies around the world and sectors. In the follow up post, I used the cost of capital as a hurdle rate to judge the quality of a company’s investments. In this one, I will use it to talk about the right mix of debt and equity, and how it affects value:

Note that as you borrow more money, your costs of equity and debt go into motion, increasing as the debt increases and the trade off from the last section plays out, with the tax benefits showing up as an after-tax cost of debt and the bankruptcy costs partially captured in the higher costs of both equity and debt and partially as drops in operating income. Note that the key changes in the 2017 tax reform package, at least as they relate to the trade off, are highlighted. I used Disney as an illustrative example, and computed the costs of capital at every debt ratio under the old tax regime and the new one and the results are in the graph below:

The cost of capital is a driver of the value of the operating assets, and since the costs of capital are higher at every debt ratio than they used to be, it should come as no surprise that the value added by debt has dropped at every debt ratio, with the new tax code.

The easiest way to see the effects of the new tax code are to look at how it plays out in the cost of capital and values of real companies. I will use Facebook, Disney and Ford as my examples, partly because they are all high profile and partly because they have widely divergent current debt policies, with Facebook having almost no debt, Disney a moderate amount and Ford more debt. With each firm, I computed the schedule of cost of capital, holding all else constant (both micro variables like EBIT and EBITDA and macro variables like the risk free rate and ERP.), with the old and new tax codes. I do this, not because I believe that these numbers will not be affected by the tax code, but because I want to isolate its impact on debt.

For all three firms, the effect of the new tax code is unambiguous. The value added by debt drops with the new tax code and the change is larger at higher debt ratios. Taking away 40% of the tax benefits of debt (by lowering the marginal tax rate from 40% to 24%) has consequences. Note, though, that the lost value is almost entirely hypothetical, for Facebook, since it did not borrow money even under the old code and did not have much capacity to add value from debt in the first place. It is large, for Disney and Ford, as existing debt becomes less valuable, with the new tax reform. Note, though, that both companies will also benefit from the tax code changes, paying lower taxes on income both domestically, with the lowering of the US tax rate, and on foreign income, from the shift to a regional tax model. Ford, in particular, could also benefit from the capital expensing provision. My guess is that both firms will see a net increase in value, with all changes incorporated. With these three firms, at least, the cap on the interest expense deduction (set at 30% of EBITDA for the near term) does not affect value at their existing debt ratios and is not a binding constraint until they get to very high debt ratios.

Debt Ratios- Cross Sectional Distributions

If you accept my reasoning that the new tax code will lower the value of debt in capital structure, and that the effect will be most visible at firms that borrowed a lot of money under the old tax regime, the only way to assess the tax code’s impact is to look how debt ratios vary across companies, and what type of firms and in what sectors borrow the most.

To get a measure of what comprises a high debt ratio, I started by looking at the distribution of debt ratios across companies, for both US and global companies:

I was surprised by how many firms in the global sample have little or no debit their capital structure, with more than half of all firms in the sample having total debt to capital ratios of less than 10%. In fact, netting cash out from debt would lead to even lower net debt ratios. That said, there is enough debt at the largest firms that the aggregated debt ratios across all firms is significantly higher. Looking at these aggregated debt ratios, you would expect US companies to have been borrowing more money than companies in other parts of the world, and to see if they did, I looked at measures of financial leverage, from debt scaled to capital to debt to EBITDA globally:

Sub Group

Debt/Capital (Book)

Debt/Capital (Market)

Net Debt/ Capital (Book)

Net Debt/ Capital (Market)

Debt/EBITDA

Africa and Middle East

45.23%

34.00%

30.27%

21.31%

5.99

Australia & NZ

61.66%

43.48%

57.82%

39.60%

8.57

Canada

55.35%

42.42%

52.46%

39.60%

7.16

China

51.63%

39.34%

41.83%

30.40%

8.52

EU & Environs

60.75%

47.17%

53.68%

40.07%

7.78

Eastern Europe & Russia

31.02%

38.05%

21.35%

27.05%

2.47

India

54.89%

20.85%

50.58%

18.15%

3.92

Japan

56.16%

49.11%

27.64%

22.35%

7.61

Latin America & Caribbean

51.67%

40.01%

46.23%

34.90%

5.74

Small Asia

44.04%

34.76%

36.01%

27.59%

4.54

UK

63.74%

46.39%

53.68%

36.33%

7.94

United States

64.06%

37.11%

60.86%

33.99%

7.09

The results are mixed. While US companies look like they are the most highly levered in the world, if you scale debt (gross and net) to book value, US companies don’t look like outliers on any of the dimensions. In fact, the only real outliers seem to be East European companies that borrow far less than the rest of the world, relative to EBITDA, and Indian companies, that borrow less, relative to market value. Looking across sectors, you do see clear differences, with some sectors almost completely unburdened with debt and others less so. While you can get the entire list from clicking on this link, the most highly levered sectors in the US are highlight below, relative to both market capital and EBITDA.

I removed financial service firms from this list, since debt to them is a raw material, not a source of capital, and real estate investment trusts, since they do not pay corporate taxes, under the old and new tax regimes. As I noted in my post on tax reform, it is the most highly levered sectors that will be exposed to loss of value and it is entirely possible that the net effect of the tax change can be negative for them.

Implications
You seldom get to observe a real world experiment of the magnitude that we will be faced with in 2018, with the tax code in change and the loss in value added from debt. Given the changes, I would expect the following:

Deleveraging at firms that have pushed to their optimal debt ratios, under old tax code: While there are many firms, like Facebook. where debt was never a source of added value, where the tax code will affect that component of value very little, there will be other highly levered firms where the value change will be substantial. In fact, many of these firms, which would have been at the right mix of debt and equity, under the old tax regime, will find themselves over levered and in need of paying down debt. Given that inertia is the primary force in corporate finance, it may them a while to come to this realization.

Go slow at firms that have held back: For firms like Facebook that have held back from borrowing, under the old tax code, the new tax code reduces the incentive to add to debt, even as they mature. As you can see from the numbers on Facebook, Disney and Ford, the benefits of debt have been significantly scaled down.

Transactions that derive most of their value from leverage will be handicapped: Since the mid-1980s, leveraged transactions have been favored by many private equity investors. While one reason was that they were equity constrained (and that reason remains), the bigger reason was that it allowed them to generate added value from recapitalization. At the risk of over generalizing, I will argue that for a large segment of private equity investors, this was the primary source of their value added and for these investors, the new tax code is unequivocally bad news, and I will shed no tears for them.

As I noted at the start of this post, debt is part of the fabric of business in the United States, and there are some businesses and asset classes that have been built on debt. Real estate and infrastructure businesses have historically not only used debt as a primary source of funding but as a value addition, with the added value coming from the tax code. Now that the added value is much lower, it remains to be seen whether asset values will have to adjust.

Conclusion
From financial first principles, there is nothing inherently good or bad about debt. It is a source of financing that you can use to build a business, but by itself, it neither adds nor detracts from the value of the business. It is the addition of tax benefits and bankruptcy costs that makes the use of debt a trade off between its benefits (primarily tax driven) and its costs (from increased distress and agency costs). The new tax code has not removed the tax benefits of debt but it has substantially reduced them, and we should expect to see less debt overall at companies, as a consequence. In my view, that is a positive for the economy, since debt magnifies economic shocks to businesses and not only creates more volatile earnings and value, but deadweight costs for society.